US Tax Reform: Taking Care of Business

As 2017 enters its final quarter, the White House and US Congress are trying to fulfill a key Republican pledge from the 2016 elections: comprehensive tax reform. The Republican Party has made grand promises. When my wife and I moved to London last year, I talked myself into a similar situation when I described to her the fantastic house we were going to live in.

But what started out as a six-bedroom townhouse in Chelsea quickly turned into the three-bedroom house we now have across the river in Barnes. Don’t get me wrong, we still have a lovely place, but when my bankers saw how much money I make and how much I wanted to take on as a mortgage, they quickly disabused us of our dream house and suggested we “rightsize” our expectations.

The Republican tax plans have a similar dilemma. Big campaign promises must face reality. Big tax cuts imply bigger budget deficits and more national debt.

The White House presented its “Unified Framework for Fixing Our Broken Tax Code” last month, filling in some detail on the planned tax reforms. As the legislative process continues, elements of the proposal will no doubt be tweaked and revised, but the current outline gives us enough data to explore how these policies might affect the US economy and investors.

Meet the Elephant in the Room

First, let’s look at the numbers. The center-left leaning Tax Policy Center (TPC) issued a preliminary study of the White House’s plans. The chart below demonstrates what they will mean for the US budget over the next 10 years based on the TPC models:

Cumulative Effects of Proposed Tax Changes on the US Budget, 2018–2027

The graphic resembles the face of an elephant, with the revenue changes from the proposed abolition of the estate tax and adjustments in income tax rates forming the pachyderm’s two eyes. The elephant’s massive trunk depicts the dramatic loss in revenue from cuts in corporate tax rates.

Let’s tackle the elephant in the room then and start with the trunk.

Are lower corporate taxes good for business?

The proposed corporate tax reforms are projected to lower federal tax revenues by a total of $2.6 trillion over the next 10 years. The lion’s share of that drop is due to a decrease in the top marginal corporate tax rate to 20% and by setting a 25% ceiling on the pass-through income tax rate for small business owners. Both tax breaks are intended to incentivize new business investment and the creation of new jobs.

The CRS also predicted a “modest positive effect” on investments and wages, which constitutes much of the rationale behind the White House’s proposal. With lower taxes, US corporations can pay their workers higher wages and still remain competitive internationally. After all, the top US corporate tax rates are among the highest in the world, and reducing the tax burden would help level the playing field between US firms and their foreign counterparts.

Indeed, as the graph below shows, US corporate tax rates are higher than even those in famously high-taxed France.

The average top corporate tax rate in developed countries is currently around 25%, about 10 percentage points lower than in the United States. Reducing the top rate would thus incentivize foreign businesses to open up factories and offices in the United States and US corporations to repatriate some of their foreign cash holdings.

Based on this logic, the trunk of our elephant should result in more foreign direct investments, higher wages, and some job growth in the United States — all desirable outcomes.

Fear What You Wish For

But investors should know that this increased competitiveness might come at a cost. After President Ronald Reagan cut taxes in the 1980s, other countries followed suit in an effort to stay competitive. The ensuing “tax war” led to lower revenue gains in the United States and higher-than-anticipated budget deficits. In fact, the CRS estimated that increased growth and wages would reduce the cost of lower tax revenues by only 5% to 6% — and that’s without a tax war.

Every study that I’ve seen on this topic shows that higher economic growth and domestic investments cannot compensate for the loss in direct tax revenue when the federal government cuts corporate taxes. Thus, the proposed reforms would inevitably lead to an increase in the budget deficit and a rising national debt.

So the trunk of the elephant will likely give the US economy a boost, though probably not as big a boost as its proponents now claim. And the cost will have to be paid in later years with larger deficits, a weaker dollar, and potentially higher inflation.

But the elephant’s trunk isn’t the whole story for the US economy or US investors. The proposed changes to income and estate taxes will also have an effect, which I will address in the second part of my analysis.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Joachim Klement, CFA, is a trustee of the CFA Institute Research Foundation and offers regular commentary at Klement on Investing. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland, and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

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